John Kay, in “Banks got burned by their own ‘innocent fraud’,” argues that banks got themselves and the world at large in a heap of trouble via self delusion. Had the bets embodied in their products been presented in simpler terms, they would have recognized that they were bogus and bound to lose money. But the complicated structures blinded them to the fact that they were bound to end in tears.

Kay draws the term “innocent fraud” from John Kenneth Galbraith and describes it as:

the process that systematically benefits one group at the expense of another but generally falls short of outright criminality.

I have trouble with the construct, and am always amazed how activities, if perpetrated by someone outside by the banking classes, are seen in a different light. The damage wrought by the credit crisis is truly colossal, but the fact that the perps (for the most part) thought the products worked and the benefits were shared makes them “innocent?” I don’t buy that. Criminality is too low a standard for deeming behavior innocent of not.

Consider the sad fate of Eben Byers, an athlete, industrialist, and man about town of the 1920s. After sustaining an arm injury that refused to heal, his doctor prescribed (and received a 17% patent rebate on) a patent medicine. Eben thought it did him a great deal of good and began taking the potion two to three times a day.

The drink, Radithor, was radium dissolved in water. Byers lost his teeth and most of the bone mass in his jaw, and before his death, developed abcesses on his brain and holes in his skull. But the maker of the toxic potion was never prosecuted, since selling radium drinks was not against the law.

By the time Byers had the vast misfortune to happen upon Radithor, the risks of radium were coming to light, as factory workers who painted radium onto clocks and would use their lips to establish a point on their brushes were developing lip and mouth cancers. But the potion-makers nevertheless continued to sell their tonics until the Byers death killed the industry. Yet by falling short of Galbraith’s low bar of “outright criminality”, the makers of radium drinks would be deemed “innocent fraudsters” even as evidence that their products were dangerous mounted.

Similarly, there were early signs that the sourcing of mortgage product was turning toxic. Warnings started surfacing in 2005. The reason that Merrill was stuck with such a large book of “super senior” CDOs was that US buyers had started to cool on the product in 2006, and salesmen were increasingly looking to overseas buyers.

Now there were no doubt many technicians, focused on their little part of the production process, who were indeed insulated from knowledge of how dubious these instruments were becoming. But using the phase “innocent fraud” lets too many people, most importantly those at the top, who should have a broader perspective, off the hook.

Moreover, innocence hasn’t worked terribly well as a defense in the securities industry. Consider the case of Joseph Jett. Jett was a government bond trader at Kidder Peabody in the early 1990s. who had seemingly found a way to exploit anomalies and was coining money, In fact, what he had found was an anomaly in Kidder’s accounting system.

Unlike other demonized rogue trades, everything Jett did was in the open. His bosses, delighted to reap large bonuses based on his outside productions, never questioned the obvious: it ought to be impossible to earn that much money in a highly efficient market. And unlike other rogue traders, Jett did not lose money, although he did cause Kidder to produce overstated profits that later had to be reversed, a huge embarrassment for parent GE.

By all accounts, Jett was convinced that his strategy really did produce real profits, He believed what the systems told him. The strongest proof that he was not knowingly perpetrating a fraud was that he kept his accounts at Kidder, where they were seized. A crook would have moved a significant portion of his gains elsewhere.

The higher-ups were never investigated; all enforcement efforts focused on Jett, who initially won a victory with the NASD but the SEC later forced him to disgorge his bonuses, imposed a fine, and barred him from any involvement with financial trading.

During the 1980s, a number of unusual financial crises occurred. In Chile, for example, the financial sector collapsed, leaving the government with responsibility for extensive foreign debts. In the United States, large numbers of government-insured savings and loans became insolvent – and the government picked up the tab. In Dallas, Texas, real estate prices and construction continued to boom even after vacancies had skyrocketed, and the suffered a dramatic collapse. Also in the United States, the junk bond market, which fueled the takeover wave, had a similar boom and bust.

In this paper, we use simple theory and direct evidence to highlight a common thread that runs through these four episodes. The theory suggests that this common thread may be relevant to other cases in which countries took on excessive foreign debt, governments had to bail out insolvent financial institutions, real estate prices increased dramatically and then fell, or new financial markets experienced a boom and bust. We describe the evidence, however, only for the cases of financial crisis in Chile, the thrift crisis in the United States, Dallas real estate and thrifts, and junk bonds.

Our theoretical analysis shows that an economic underground can come to life if firms have an incentive to go broke for profit at society’s expense (to loot) instead of to go for broke (to gamble on success). Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations.

Had anyone taken this line of thinking seriously, we might not be where we are today.

How could banks have persuaded themselves, their shareholders and the public that they were making so much money when in reality they were losing it? The history of financial deception and self-deception is as old as humanity, but a few themes recur. A Ponzi scheme offers a high return using the funds of newcomers to make payments to earlier subscribers, and collapses when the supply of suckers runs out. The New Economy was the greatest of Ponzi schemes. It has been different this time. But not so different.

I have several times in this column described the Taleb distribution of regular small profits interspersed by large losses. Taleb distributions are the basis of the carry trade – which exploits interest rate differentials – and many types of statistical arbitrage. Taleb distributions are exploited by traders in hedge funds and at proprietary trading desks.

The martingale is not an exotic bird but a gambling strategy. Imagine a coin-tossing game in which you win on heads. Every time you lose with a tail, you double your bet. Simple arithmetic shows that when you eventually throw a head, you will recoup all your earlier losses and make a small profit. Ultimate success seems guaranteed.

Little worldly wisdom is required to realise that the more usual outcome is bankruptcy. But when the concept is dressed up as a collateralised debt obligation, the problem seems less obvious. If the credit initially provided is inadequate, the issuer will top it up. Moreover, such instruments fitted with the models of rating agencies. Simulations of performance, run with the benefit of powerful computers but without the benefit of common sense, show how martingales may deliver small, predictable returns.

Their once attractive valuations depend on the ability to anticipate future returns. The adage that a bird in the hand is worth two in the bush is now old hat. A conservative accountant counts the bag at the end of the shoot and a less conservative one registers the numbers as the birds fall from the sky. But the modern accountant not only eats what he kills but also takes credit for the expected cull as soon as the hunters’ guns are primed.

Mark-to-market accounting is criticised today for forcing banks to recognise that unsalable assets have little value. Companies resent the obligation to use mark-to-market accounting when the market is down. But the public should be more concerned for the implications of mark-to-market accounting when the market is up. The authors Bethany McLean and Peter Elkind describe how Enron’s Jeff Skilling, in a fit of uncharacteristic generosity, once ordered champagne for all his colleagues. The toast was in appreciation of a letter from the Securities and Exchange Commission agreeing that Enron could make wide use of mark-to-market accounting.

Mr Skilling believed, as do many traders and financiers, that people should receive credit for the full discounted expected present value of their ideas at the moment of inspiration. Newton, thou shouldst be living at this hour! But it is easier to reward people on the basis of what they believe they are worth than to recover bonuses from people whose ideas turn out not to have been as good as they thought. Even Newton’s heirs might have struggled to repay when Einstein demonstrated flaws in Newtonian mechanics.

Ponzi schemes, Taleb distributions and martingales, revenue recognition and mark-to-market accounting: these are the means by which successive generations of financial hotshots perpetrate what John Kenneth Galbraith described as innocent fraud. This is the process that systematically benefits one group at the expense of another but generally falls short of outright criminality.

But to benefit from the innocent fraud, you must be organiser rather than participant. In the New Economy, banks collected commissions on transactions but limited their own direct involvement. The participation of banks in the recent round of follies brought humiliation. Is the deception of others more or less venal when one has also deceived oneself? That question must be left for moral philosophers – and historians of our era – to answer.

It puzzles me that John Kay is considered a brilliant economist by some. I used to read his columns but rarely could understand his logic. For some time I believed this to due to intellectual shortcomings on my behalf until it occurred to me one day that Mr. Kay is in fact quite mad.

Kay didn’t make a lto of sense but I take it everyone on Wall Street is looking for some form of absolution these days. Too little too late. Just wait until the anger from Main Street really hits Wall Street.

“But the public should be more concerned for the implications of mark-to-market accounting when the market is up. The authors Bethany McLean and Peter Elkind describe how Enron’s Jeff Skilling, in a fit of uncharacteristic generosity, once ordered champagne for all his colleagues. The toast was in appreciation of a letter from the Securities and Exchange Commission agreeing that Enron could make wide use of mark-to-market accounting.”

John Kay writes: “Is the deception of others more or less venal when one has also deceived oneself? That question must be left for moral philosophers – and historians of our era – to answer”.

Absolutely not! We cannot afford to leave this question to moral philosophers or historians.

The question that John Kay poses paints out the possibility that the guilty party is innocent because it “has also deceived” itself and this, in this case at least, is unacceptable. The Financial Regulators should have known that creating a system that empowered so much so few with providing information to the market as the regulators did with the credit rating agencies was bound to lead to a crisis like the one we are having.

The Financial Regulators might argue that “they did not know it”, but that only puts the burden squarely back on us to place the regulation of the financial sector in the hands of persons capable of knowing such fundamentally simple things of life and financial markets.

Unbelievable. The author treats us like mushrooms—feeding us shit and keeping us in the dark.

It’s not “innocent fraud”—it’s passive fraud. A gigantic game of “Don’t look/Don’t tell”….

All the examples of fraud in this crisis–from your garden variety mortgage fraud…to the exotic derivative investments which were destined to fail— are riddled with non-disclosure and an intent to deceive. Only, the one being “deceived” is actually encouraging the deceit. Innocent fraud? More like a self-induced fraud…or better yet: A murder by suicide.

Only the murderer/victim thought–in the worst case scenario–it’d be able to collect a nice fat insurance benefit.

http://www.dailywealth.com/archive/2008/oct/2008_oct_04.asp“Sources inside Goldman say the company’s exposure to AIG exceeded $20 billion, meaning the moment AIG was downgraded, Goldman had to begin marking down the value of its assets. And the moment AIG went bankrupt, Goldman lost $20 billion.”

I think Kay has set forth a contradiction in terms by using “innocent fraud”. My understanding of the term fraud is that there needs to be three ingredients:

1)Damages to another party

2)Misrepresentation of facts

3)The misrepresentation must have been willful

Kay’s entire argument is based upon the premise that the perps weren’t aware of the true consequences of their actions (it wasn’t willful). Therefore, technically he should be arguing that there was no fraud (other crimes perhaps but not fraud).

If, on the other hand, he’s arguing that the perps understood the consequences of their actions and still purposefully mislead others- but- the severity of their crimes should be mitigated by the fact that the perps also lost money on the deals-then- it’s just a lousy argument. All it proves is that the crooks were nefarious and stupid. No leniency!!!

Ps- Yves, while the doc in your story may not have been guilty of fraud (even though he got the rebate payment) he should have been charged with negligence. Do you know what happened to him?

This bailout and the fraud attached to it goes to the simple legal concept of The Prudent Man Rule.

The Prudent Man Rule directs trustees “to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested”.

While Akerlof and the Chile example have received some attention the cases in India have received very little attention as far as I can tell.

During the 70s and 80s India was very much into import substitution and self sufficiency and all that. As a fresh engineer coming from a patriotic family I was all for it. The various state governments had set up industrial zones to help entrepenuer engineers to produce import substitution goods. Looking at these industrial zones, GIDC in Wapi specifically, that most of the factories in this zone were shells. They had received significant investments from the Gujarat state government with close to 0% investment by the promoters. Thse promoters would ask for more and more loans to stay in business and the GIDC would give them the money because they thought that this will help protect their original investment. When GIDC would stop giving further loans, these promoters would declare bankruptcy, start a new shell corporation, and apply for new loans all over again. Of course the GIDC officials were getting a cut and a newbee like me with a serious intention to manufacture did not have a chance in hell to get a loan approved.

Since I don't trust people to look at links, I need to post this from that link, because I have an obligation to provide quality information here, even if this is somewhat outdated:

>> The 10,000+ mutual funds of 2000 have grown to over 15,000 mutual funds in 2006. Does any advisor claim to be expert on all of these funds? Does any one of the rating agencies promise that the funds they rate highly will perform better than those they don't? The Prudent Man Rule is even more important today than it was in 1830 if for no other reason than that the market has become so complex and no individual advisor or advisory firm can claim to be fully informed about the investments they recommend. Remember, ENRON, WORLDCOM, QWEST?

Personally, I find it fascinating to read all these stories about the “whodunit” and who should have known when/why or who should have done what/how. It is certainly a critical element of history and of whatever lessons, if any, we are to learn from this debacle.

The search for these “truths” however, runs the risk of diverting us from the most consequential discussion that ought to be had. The governments’ handling of the crisis, while regrettably necessary in terms of its intrusion into the markets, needlessly has stripped away the most effective medicine to prevent crises like these from reoccurring.

Absent the harsh reality of having to suffer through the consequences of their negligent actions, these cretins are sure to repeat their same mistakes. History certainly tells us this to be the case. Both management and shareholders should have seen their stakes suffer the full brunt of their misguided policies. The taxpayer’s funds should have never been allowed to shield them from this most critically needed accounting and facing up to their responsibilities.

There is no innocence where there is intent, and the intention is clearly shown in the lobbying activities of the financial sector to overturn Glass-Steagall and override and circumvent the regulatory processes with off-balance sheet shenanigans.

I’m not buying this, mainly because I believe that one reason they allowed the high risk was knowing that there would be a government bailout.

Plus, the following:

A Cascade Of Poorer Loans?An answer to an earlier post using Credit Default Swaps as an illustration. From Vox, by Virginie Coudert Mathieu Gex :

“The CDS market is now in the eye of the storm. The reason is straightforward, because this crisis is about credit risk. A credit bubble has ballooned for years, being enhanced by the existence of credit derivatives. As credit originators can pass their risk to other agents, they have been less careful about the quality of their loans. In that sense, CDS have given an incentive for distributing more credit to more risky borrowers.”

So that explains lending to people who might not pay you back.

And, on no regulation as opposed to minimal and effective regulation:

“Another cause for concern is that the market is unregulated. CDSs act as insurance against default, but they are not submitted to any regulations as is the case for insurance companies. The latter have to meet required reserves and are closely monitored by public authorities. On the CDS market, no reserves are required from the sellers of protection, only very thin margins, ranging from 2% to 5% of the amount insured. However, the danger is even greater than insuring against natural catastrophes for example, because of the high correlation of default risk, which is linked to the business cycle.”

As one of the posters said above, it should probably be termed passive fraud, not innocent fraud. Actually, the word fraud is probably wrong too. It is neither innocent nor is it fraud. It is certainly nonfeasance, continuing to take the money, continuing to delude yourself, continuing to fail the basic due diligence requirements. But if you’re waiting for a world in which each individual polices himself or herself, I suspect you will be waiting a very, very long time. I suspect almost anyone would have done the same in that position. Talk about delusion, it is the crazy idea that we are better than these people, that we are better than the German citizens who supported the Nazis or the Japanese citizens who supported Japan’s military during WWII to the bitter end. “No man chooses evil because it is evil; he only mistakes it for happiness, the good he seeks.” We cannot police ourselves or our power centers without extreme vigilance.

Let’s all say it together. Some regulation, good. Some regulation, bad. I know, it is a tremendously difficult concept to introduce gray into everyone’s world of black and white, but I think it’s still worth trying.

Government encouraged the housing bubble with lax regulations, low interest rates and easy money. The bubble burst and there is nothing the government can do to stop the stock market decline. The reason that capitalism works so well is because, normally, the people who caused the economic problems pay for their hubris through bankruptcy. Instead, this government is making the eventual economic crash worse because they are giving $2 trillion dollars of taxpayer money to the bankers who caused this economic fiasco. The only reason Wall Street crooks are not in jail with Enron’s Jeffrey Skilling is because the banking industry handsomely pays off Congress with huge campaign contributions, especially, Sen. Christopher Dodd, Sen. Chuck Schumer and Rep. Barney Frank.. Americans are not going to have the money they need at the recession bottom because the Federal Reserve is a captured quasi-government institution whose main goal is to make sure bankers are protected at all cost.

The corruption of synthetic derivative abuse, was the fuel for the Housing Bubble and Dotcom Bubble! Don't deny the reality of the easy liquidity and Tsunami Of Cash that gets these balls rolling (out of control)!

If regulators would have been honest, we wouldn't have ended up with wal-mart monopolies and millions of starbucks and a massive inventory of unsold homes!

FYI: From about 2003>> "Last year, the company added a staggering 40 million sq. ft. of retail space to its portfolio, all seemingly without breaking a sweat, lending credence to Scott's contention. Wal-Mart plans to add another 1,500 Supercenters to its base in the U.S. over the next five years, a 40% increase, or close to 300 million sq. ft. of new retail space. "I'm not trying to be flippant," Scott recently told Time magazine, "but we plan to be everywhere we're not."

FYI: After Wal-Mart opened 281 new stores in the U.S. in 2007, CEO Lee Scott said that the retailer would scale back store openings and growth in 2008. This year, the retailer will open just 180 stores, with only 140 planned for 2009."

I enjoyed your site and I would love to speak with you about possibly working together to help us bothbe more successful and make you more money, without you having to lift a finger. If you are interested in speaking please give me a call. We have a lot of great material that I think your readers would appreciate you introducing to them. I can set you up with a staff membership of our products first so that you can see what we have to offer. Best of all this is not costing you a thing in fact every month you will make extra money

Do you work with any strategic partnerships? If you have a chance you could send me over your ad rates as well as some traffic statistics.I know you are busy but if you have a chance take a look at our site http://www.ino.com and let me know what you think.

3 factors have made this crisis what it is:1) Abuse of leverage2) Abuse of derivatives3) Absence of enforcement.

As Barry Ritholz wrote recently, there is a reason we got referees in pro sports: we, humans are very competitive, we try to push the boundaries of the permissible to gain an edge. Hence, the need for an enforcer…to keep us honest, so the game can have staying power and do what it is intended to do.

Maybe, just maybe, such plain common sense will be back in vogue someday. We’ll then look back and shake our heads, wondering how so much hocus-pocus gonzo-shithead ideologies like trickle-down economics and auto-regulated markets could ever become a dominant philosophy.

Collective financial insanity can only be cured by giving tenure to Prof. Pain, the only Master we end up listening to.

Market down 750 but the MOST IMPORTANT thing to happen today was TRICHET saying we need a return to discipline with a hat tip to bretton woods. Something is brewing and it is going to be ugly for the US. Game changer coming. US will hold the devalue gun to its head but one can imagine the rest of the world hoping it’s not a bluff.

Akelof and Romer had it exactly right. ” Bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations.”

Just change the word ‘owners’ to ‘executives’ and it describes the situation at banks to a T.

Wouldn’t be quite the spectacle to line all the fraudsters up, tar and feather in front of the Washington monument, and leave them out their on display for everyone to come and gawk for a few weeks. Then, right next to the vietnam wall, another wall of shame gets built for all the banksters.

I don’t know Kay’s writings well enough to venture that he intends “innocent fraud” ironically; Galbraith certainly did. Maybe Kay doesn’t, since he asks for what every moral philospher knows the answer. To include others in one’s self-deception is the most venal, for it compounds the initial corruption of one’s self.

John Kay’s stance is not grounded in corporate ethics or law. The corporate directors and managers had a duty to their shareholders and an overall ethical duty to stakeholders to make sure they DID understand the complex products and structures. Failing to do so would mean admiting guilt….thereby inviting lawsuits.

So it remains that everyone will just shrug their shoulders and say “I didn’t understand” in order to escape liability.

John Kay is saying the corporate CEOs are no better than the average joe who signed mortgage papers “he didn’t understand.”

There were plenty of banks that DID understand and decided NOT to originate subprime loans. Example: Homestreet Bank in Seattle.

Back in the days when JP Morgan ruled the roost, the only thing that mattered before anything else was a man’s character.

If some slickster approached JP 10 years ago with a so-called gilt-edged AAA CDO, or whatever other type of unregulated snake-oil for sale, they ‘d have gotten narry a dime out of him, if the man behind the snake-oil had no character. At the Pecora hearings, JP under oath anwered Untermyer’s line of questioning as followw:

Untermyer: Is not commercial credit based primarily upon money or property?

Pierpont Morgan: No Sir, the first thing is character.

Untermyer: Before money or property?

Morgan: Before money or anything else. Money cannot buy it…Because a man I do not trust could not get money from me on all the bonds in Christendom. ~ JP Morgan’s testimony during his cross-examination at the Pujo hearings May 1912 to Jan 1913

Had, the old bankers code still applied, these stinking products would never had gotten very far in their propogation

The English legal test for the culpable state of mind that comprises fraud does not require full-blown conscious intention: recklessness is sufficient. A reckless disregard for the truth of representations of fact or law is fraud. The same goes for the criminal offence of deception and the tort of deceit. In reality, if the evidence shows that the wrongdoer must have known the truth, then a defence based on some psychological state of denial would be unlikely to succeed.